Buy Broken Stocks, Not Broken Companies

Buy broken stocks, not broken companies. It’s a longtime Cramer maxim, and a sell-off can be the best opportunity. But how does an investor tell the difference?

Usually, broken companies lead the decline. They’re the reason the sell-off is happening in the first place. In 2007, weak real estate, bad loans and mortgages and the bonds that backed them all lead to the credit crisis. So any company related to housing, lending and mortgages was probably broken.

More recently, a combination of concerns caused stocks to fall in summer 2011, including the U.S. debt ceiling, S&P's credit rating downgrade and liquidity concerns in Europe. All of these things led to a steep sell-off and increased volatility.

Aside of the companies that were at the center of the fray, there’s another group whose profitability is affected even though these companies aren’t directly related to the cause of the sell-off. Cramer offered retail during 2007 as an example because the credit crunch had killed the spending power of the consumer. In 2011, the financials are a good example because these companies remain in the "cross-hairs of government regulation" following the Great Recession. Slower gross domestic product growth means slower growth for the sector, he explained.

But a company isn’t broken just because the stock price dropped. It’s only when the reason for liking it is gone that a company attains that status. Just look at the other sectors in 2007 that dropped when housing and credit took the market down. Infrastructure, oil and agriculture were all strong industries that took at hit even though they weren’t factors in the decline. This occurred again in summer 2011.

The stocks went down because all stocks were going down, Cramer said, but there wasn’t a connection to the causes of the sell-off.

So when looking for opportunity in a sell-off, he recommended buying stocks in sectors that are independent of what’s ailing the market.

A note of caution: Even if you think a bottom is approaching, and the worst performers will become the best, avoid those stocks, Cramer said. Once a company breaks, it’s difficult to mend itself. And that’s only more true for sectors, which control half of a stock’s movement.